Profit

Income

Income consists of sales receipts, interest income, and a variety of other items that are often lumped together into a category called nonoperating income. Because most firms use accrual accounting, the sales line item on an income statement usually includes both cash received from sales, and also the selling price of goods that have been sold, but for which money has not been collected. Other items that would be included in income are dividends on shares of stock the firm owns, and license or royalty payments.

Expenses

Expenses are more complicated. Expenses include many of the obvious items that a firm writes checks to pay for: costs of raw materials, labor wages, electricity, maintenance, advertising, interest payments, and taxes. It also includes some items that a firm does not actually pay for, called noncash expenses, such as depreciation. Under GAAPs accounting, a firm is not allowed to deduct the entire amount it spends on capital equipment in the year the equipment is purchased. Instead, the firm must “depreciate” the equipment over its expected life, which means charging [Page 456]a portion of the initial cost of the machine each year of its life. So, for example, if a firm were to purchase a $100,000 piece of equipment, it typically would not be allowed to include as an expense in the purchase year the $100,000 it paid for the equipment. Instead, the $100,000 must be expensed over the expected life of the equipment. If the expected life is 10 years, then the firm records $10,000 per year as an expense. In the first year the firm pays out $100,000 for the equipment, but only claims an expense of $10,000. In years 2 through 10, the firm records a $10,000 expense when, in fact, it pays out nothing for the equipment. This means the expenses a firm records do not correspond to the cash the firm pays out! In years 2 to 10 the firm records noncash expenses of $10,000 each year.

...